I just started investing in a non-registered account, and I was wondering whether REIT dividends are considered interest income or not.

This is a great question, with a rather complex answer. The best way to tackle it is with a couple of examples.

The first we’ll look at is RioCan REIT, Canada’s largest real estate investment trust. If you go to RioCan’s website and click on “Investor Relations,” you’ll see a link that says “Distribution Info.” (Notice RioCan uses the word distribution, not dividend, because the cash it sends to investors every month doesn’t qualify as a dividend. More on that in a moment.)

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If you place your cursor over “Distribution Info,” you’ll get several options, one of which is “Income Tax Information.” Click on that, and you’ll go to a page that summarizes RioCan’s distributions going back nearly two decades. For each year, the company breaks down the components of its distribution.

For example, in 2011, RioCan distributed $1.38 a share to unitholders (or 11.5 cents a month.) Of that amount, 31.24 per cent was classified as “other income,” 1.72 per cent as “capital gains,” 4.57 per cent as “foreign non-business income” and 62.47 per cent as “reduction in adjusted cost base.”

Keep in mind, if you hold RioCan or any other REIT in a registered account, the tax breakdown doesn’t matter because you won’t pay any tax on the distributions. It’s only in a non-registered account that you need to pay attention to the components of the distribution. The good news is that you’ll get the full breakdown, in dollars, on your T3 tax slip, which makes it relatively easy to file your taxes. But visiting the company’s website will help you understand the tax treatment of the distribution.

Let’s look at each of the categories in order.

Other income is taxed at your marginal rate, just like interest. Capital gains are taxed at half your marginal rate. Foreign non-business income, which typically reflects rental revenue from U.S. properties, is also taxed at your full marginal rate. Reduction in cost base – also known as return of capital or ROC – requires a bit of an explanation.

When you receive ROC, you are not taxed immediately on the amount. Rather, you subtract the ROC from the adjusted cost base of your units. This gives rise to a larger capital gain, or smaller capital loss, when you ultimately sell your units. Because of the tax deferral, ROC is considered tax-efficient income.

Now let’s look at a second example, Canadian REIT.

Again, you can view the tax breakdown of CREIT’s distribution on its website. In 2011, CREIT paid $1.43 in distributions, of which 79.04 per cent was classified as other taxable income, 4.64 per cent as capital gains, 3.66 per cent as foreign non-business income and just 12.66 per cent as reduction of adjusted cost base.

The interesting thing to note here is that, compared with RioCan, a much larger percentage of CREIT’s distribution is fully taxable in the current year, while a much smaller proportion is classified as tax-deferred ROC. So, in a non-registered account, CREIT investors would take a comparatively large tax hit.

Investors should therefore examine a REIT’s distributions carefully, because the tax characteristics may influence whether you hold the REIT in a registered or non-registered account. Keep in mind, however, that the percentages change from year to year.

“You really want to look to the nature of the distribution. Our general advice is if something is highly taxed, you want to hold that in a registered account,” says Jamie Golombek, managing director, tax and estate planning, with CIBC Private Wealth Management.

“If you’ve got a REIT that has a large percentage of income, including foreign non-business income, that is fully taxable, you would probably want to hold that in a registered account so you don’t pay tax on that investment income.”

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